Why slowing expansion in Texas means painful news for REITs

The Dallas Fed Manufacturing Index is a manufacturing-focused index of business activity

The Dallas Fed conducts its Texas Manufacturing Survey monthly, and it’s similar to many of the other regional Fed surveys, like the Empire State Manufacturing Survey, the Chicago Fed National Activity Index, or the Philly Fed. These are all diffusion-type indices that ask respondents whether a certain metric is increasing, decreasing, or staying the same. It subtracts the percentage of people reporting a decrease from the number of people reporting an increase to come up with the results. In other words, if businesses are asked about their hiring plans, and 30% say they intend to add to payroll, 45% say they’re holding steady, and 25% say they’re decreasing payroll, the index would be 30 – 25 = 5. That’s generally how all diffusion indices work.

The Dallas Fed survey asks about output, employment, orders, prices, shipments, inventories, capacity utilization, prices, capital expenditures, and some other indicators. It asks respondents for their six-month outlook and usually about a subject in depth.

Highlights of the survey

The General Business Activity Index fell to 0.3 from 3 the month before. The outlook was still positive—albeit less so in February. Capital expenditures fell, although most other sub-indices were increasing. Most survey respondents mentioned the weather as an issue. Overall, it’s a positive reading, but not quite as strong as a few months ago.

Impact on mortgage REITs

Interest rates are the biggest driver of mortgage REIT returns, and nothing in this report would encourage the Fed to change its current course. The employment indices were encouraging, and the prices paid and received were flat. This is consistent with the Fed’s current path: tapering quantitative easing as the labor market improves and leaving short-term rates as low as it dares as long as inflation behaves. Still, it’s been a painful adjustment period for the REITs—as the ten-year bond has sold off, mortgage REITs, like Annaly (NLY), American Capital (AGNC), MFA Financial (MFA), and Hatteras (HTS), have under-performed.

Increasing rates are a double-edged sword for the REITs. On one hand, continued low rates mean their cost of leveraging their portfolio is low, but on the other hand, they take mark-to-market hits on their portfolio even as interest margins increase. Although increasing rates will decrease prepayment risk for the REITs, increasing real estate prices would allow some FHA borrowers to refinance into a conforming mortgage and save on mortgage insurance payments. Prepayments will negatively affect mortgage REITs, as they’re forced to reinvest into lower-yielding paper.